The Meaning of Supply and Demand
Fred Foldvary
[Reprinted from a Land-Theory online
discussion, December 1999]
Roger Sandilands:
But if we are interested in the underlying nature of the real
economy, and want to get behind the "money veil", then a
shift in the demand schedule is the same thing as a shift in the
supply schedule. If tomorrow everyone were 5 percent more productive
then (abstracting from differing demand elasticities, or assuming
that resources shift easily from low to high demand elasticity
sectors) the aggregate demand would also shift up by 5 percent in
real terms.
Fred Foldvary:
We have more of a disagreement on terminology than on the
economics. But the terminology is important in keeping our thoughts
and communications clear.
The aggregate supply curve would shift out to the right to a
higher output.
The aggregate demand curve depends on money income, and would stay
put, since the quantity of money is the same. The greater supply
would then cross the demand curve at a lower price level. If the
money supply does not increase, then the effect of greater
productivity is to lower prices.
If you are saying that when aggregate supply shifts out, the
quantity demanded will equal the quantity supplied, I agree. But
that extra quantity demanded is not due to a shift in demand but to
a movement down the aggregate demand curve to a lower price level.
Of course if the money supply increases by the same proportion as
the supply, then the demand will shift out. But in the above, you
say nothing about increasing the quantity of money flow (MV).
Roger Sandilands:
In a very flexible and competitive economy, prices would tend to
fall throughout the economy by 5 percent if the money supply was
held constant. Or the authorities could expand the money supply by 5
percent to keep the general price level steady.
Fred Foldvary:
If prices fall with constant money, the demand, meaning the whole
curve, is not shifting. If money expands, that shifts the curve out,
since for any given amount of output, the price level would be
higher.
Roger Sandilands:
Now go back to microeconomic supply and demand. Why would demand
for widgets increase? Maybe because widgets are the flavour of the
month. But more likely because national income has increased, either
in money or in real terms. If in money terms only (i.e., inflation),
the costs of widget-making will almost certainly have increased too.
Then the supply (cost) curve will not be independent of the shift in
the demand curve. Both shift upwards from a common cause
(inflation).
Fred Foldvary:
Not so. The supply curve for widgets is independent of the demand
because the supply curve is a relationship between price and
quantity, holding everything else constant. If the money supply
increases, then everything else is not constant, and the curve
shifts. The shifting of supply is not independent of demand, but the
supply curve, which is only a relation between price and quantity
with all else constant, is independent of everything other than
price and quantity.
Roger Sandilands:
Adam Smith introduced the Wealth of Nations by stating that
productivity depends on the division of labour and specialisation.
And that the division of labour is limited by the size of the
market. So when, in the aggregate, market demand (in real terms)
increases, we can expect that outwardly shifting supply curves are
the cause and the consequence. Growth has an underlying tendency to
be cumulative and self-sustaining. Supply creates its own demand.
Fred Foldvary:
The last statement was by J. B. Say in the early 1800s, but he did
not express it that way. "Supply creates its own demand"
is from Keynes. What Say said in "Say's Law" is that in
creating a supply, the factors are paid that amount that enables
them to buy the supply, hence additions to quantity supplied will
equal additions to quantities demanded.
Roger Sandilands:
And so, to return to Victor's original point, if the aggregate
demand for loans shifts, we can be pretty sure that that shift in
demand will not have been independent of the supply of loanable
funds (and vice versa).
Fred Foldvary:
A shift in the demand for loans is indeed independent of the
supply. The supply of funds comes from savings. The demand comes
from investors and consumers. It is possible that more folks want to
borrow, while folks don't want to increase savings as much. Then the
interest rate rises to equilibrate the added demand.
If aggregate output is expanding while the supply and demand
ratios of savings to consumption is constant, then the shift in
demand for loans is matched by a shift in savings, because both are
growing at the same rate. But this is not necessarily or even
usually the case.
Roger Sandilands:
But Fred, what happens if real demand increases in the schedule
sense?
Fred Foldvary
If demand is measured in terms of money (MV; money stock times
velocity), then there is no real demand but only a nominal demand.
In a moneyed economy, MV=PT (price level times transactions), and
the aggregate demand is MV/P at various levels of P, holding MV
constant, hence nominal (moneyed) since it is a function of M.
In a barter economy, people purchase goods with goods, so the
aggregate demand is vertical and coincides with the aggregate
supply, since the price level is irrelevant. The ratio of trading of
one commodity against all others is irrelevant to the total demand
for goods, since what is exchanged is not that one commodity but all
commodities against all commodities. But then the whole concept of
aggregate demand and supply is then meaningless, since these are
schedules of the price level and output. There is only output, and
no price level. So in effect, there is no supply and demand at all,
but only some aggregate quantity of goods supplied and some
aggregate quantity demanded, and they are equal.
Hence, as I see it, the concept of aggregate supply and demand
imply the existence of money and a price level, and aggregate demand
is not real but always nominal. The aggregate quantity of goods
demanded is real, and equal to the aggregate quantity supplied, but
it is not demand but a point on the demand curve, or specific item
in the schedule.
Roger Sandilands:
Can you then say that this new demand schedule intersects the
(vertical) supply schedule at a higher price?
Fred Foldvary:
No, because there is no real aggregate demand curve.
Roger Sandilands:
Or would you have to admit that an outward shift in the demand
schedule cannot occur except via an outward shift in the supply
schedule? I am genuinely puzzled by my own question.
Fred Foldvary:
I think the puzzle is resolved by realizing that aggregate demand
is moneyed.
Roger Sandilands:
Perhaps the answer is that the demand schedule in real terms
cannot shift outwards; that there can only be a movement down an
aggregate demand schedule to effect the secular increase in
*quantity demanded*?
Fred Foldvary:
That's it.
Roger Sandilands:
Another way of looking at it is to say that through time the
downward-sloping real demand schedule actually coincides with a
downward-sloping aggregate supply schedule.
Fred Foldvary:
No, the aggregate supply schedule is either vertical (independent
of the price level) or else, in a Keynesian situation with
unemployment and a fixed nominal wage, upward sloping. Over time, as
output grows, the aggregate supply shifts out to the right.
\
Roger Sandilands:
But I can see some advantages to your preference for a constantly
outward shifting vertical supply schedule.
Fred Foldvary:
Yes, vertical in the classical world of flexible wages and prices.
Roger Sandilands:
"In the aggregate supply is demand is supply." Why?
Because we live in an exchange economy and we can only demand real
things if we offer something real in exchange.
We can analyse widgets on the assumption that suppy and demand are
independent, but we this is not how we should analyse the supply and
demand of GDP (aggregate supply and demand).
Fred's analysis of aggregate supply and demand to determine the
aggregate price level is not wrong, but it is not quite the same
kind of point I was making in response to Victor's analysis of the
market for loanable funds.
When we look at the supply and demand curves for widgets to
determine the equilibrium price of widgets, we are looking at a
particular price and assume all other prices are constant. We in
effect find the *relative* price of widgets. But when Fred looks at
an aggregate supply curve -- more or less vertical at full
employment -- and superimposes an aggregate, downward-sloping demand
curve, he is trying to find the *general* price level.
If demand shifts upward it's presumably because there has been an
increase in the money supply -- an increase in *monetary* demand --
and the price level drifts upwards, more or less pari passu with the
money supply. The price of widgets and everything else tends to rise
in the same proportion. Nothing "real" has changed --
price relativities are unchanged. This is the neutrality-of-money
proposition. Of course it's a simplification, and real things do get
upset by monetary shocks in the short run.
But if we are interested in the underlying nature of the real
economy, and want to get behind the "money veil", then a
shift in the demand schedule is the same thing as a shift in the
supply schedule. If tomorrow everyone were 5 percent more productive
then (abstracting from differing demand elasticities, or assuming
that resources shift easily from low to high demand elasticity
sectors) the aggregate demand would also shift up by 5 percent in
real terms. In a very flexible and competitive economy, prices would
tend to fall throughout the economy by 5 percent if the money supply
was held constant. Or the authorities could expand the money supply
by 5 percent to keep the general price level steady.
Now go back to microeconomic supply and demand. Why would demand
for widgets increase? Maybe because widgets are the flavour of the
month. But more likely because national income has increased, either
in money or in real terms. If in money terms only (i.e., inflation),
the costs of widget-making will almost certainly have increased too.
Then the supply (cost) curve will not be independent of the shift in
the demand curve. Both shift upwards from a common cause
(inflation).
If there has been a real increase in GDP (and assume no change in
the overall price level) then it is because the various sectors
(widgets, food, transport, etc, etc) are more productive; their unit
costs have fallen and so their supply schedules shift out and down.
Perhaps widget makers do not share in the productivity improvements
that have caused GDP to increase. In that case their cost schedule
is unchanged and the increase in demand for widgets will increase
their absolute and relative price. But this must have been an
exception, otherwise GDP would not have increased. Overall,
individual demand schedules have shifted up because a host of supply
schedules have shifted down. Overall, on the reasonable assumption
that wants are insatiable, and that the *overall* income elasticity
of demand is equal to unity, demand has increased in line with
supply.
We could of course object that the above story ignores the
business cycle, with Austrian, monetary, Georgist, Schumpeterian, or
whatever causes. But in the long run, the above shows why supply is
demand is supply.
Adam Smith introduced the Wealth of Nations by stating that
productivity depends on the division of labour and specialisation.
And that the division of labour is limited by the size of the
market. So when, in the aggregate, market demand (in real terms)
increases, we can expect that outwardly shifting supply curves are
the cause and the consequence. Growth has an underlying tendency to
be cumulative and self-sustaining. Supply creates its own demand.
Keynes was supposed to have buried Say's Law. But he only showed
why monetary disturbances can interrupt the underlying trend. Henry
George gave an equally plausible explanation for the interruptions,
and also concentrated on the question whether the fruits of secular
progress were properly and healthily distributed. But in answering
the Big questions he did not play around with microeconomic supply
and demand curves. For, in the aggregate, supply is demand is
supply.
And so, to return to Victor's original point, if the aggregate
demand for loans shifts, we can be pretty sure that that shift in
demand will not have been independent of the supply of loanable
funds (and vice versa).
Roger Sandilands:
This supply and demand schedule game is the stuff of introductory
textbook economics. Later on, some students maybe, just maybe, learn
that when one of the schedules shift it is unlikely that the other
schedule will be unaffected. In the aggregate, supply is demand is
supply.
Cliff Cobb:
I don't understand what you are saying here. Isn't it axiomatic
that supply and demand are determined independently? I think there
may be problems with that assumption, but I understood that that was
the basis of all micro analysis: two equations and two unknowns.
Fred Foldvary:
We first need to clearly distinguish between the demand for a good
or factor, and the aggregate macroeconomic demand for all goods. For
goods, the vertical axis is price. For the economy, the vertical
axis is the price level, such as measured by a price index.
The agg demand curve presumes all is held constant other than the
price level and total output. So money is also constant. Given
constant money, hence a constant income, the lower the price level,
the more goods that amount of money can buy. Hence the agg demand
slopes down.
Meanwhile, the agg supply can be vertical or slope up. So they are
independent and will cross to determine the price level and total
output. In a full-employment economy, the agg supply will tend to be
vertical, i.e. output is independent of the price level. So an
increase in money shifts out demand but only raises prices, not
output.
Roger Sandilands:
But, re the implications for microeconomics, would we agree that
the upshot is that while (i) there are analytic advantages in
drawing individual (microeconomic) supply and demand schedules as
independent of each other, with one capable of shifting without the
other shifting also, nevertheless (ii) the ceteris paribus
assumption that lies behind these abstractions can be highly
misleading. Why? Because the forces that cause the one to shift (in
particular, the size of the aggregate market) almost always are
acting simultaneously on the other schedule too.
And this is likely to be particularly true of the market for
loanable funds where the demand and supply schedules both depend on
aggregate income. (And/or, in the market for loanable funds to
finance real estate, by the speculative rise in the price of the
assets that are changing hands -- so that my purchase equals your
sale proceeds that you may put back into the loanable funds market.
And vice versa when the bubble bursts. When the market is
rising/falling, do not both the supply and demand schedules for
loans increase/decrease?)